The 529 plan's ability to accrue and distribute free of taxes is possibly the best game in town for any taxpayer.
The new tax laws have made 529 accounts more attractive as estate planning devices. You all know that contributions to a 529 account must be in cash, but then can grow free of federal (and often state) income taxes until distributions are made. Under the new 2001 tax laws, those formerly taxable distributions are not (for now) taxed at all, if used for “qualified” purposes, such as college tuition and education-related expenditures.
The changes open up the door for planning. If you run the math, the 529 plan's ability to accrue and distribute free of taxes is possibly the best game in town for any taxpayer, regardless of income level. At least until 2011, 529s appear to be the winners over Uniform Transfer to Minors Act or Uniform Gift to Minors Act accounts, Crummey trusts, minors' trusts, or an IRA education account.
An Achilles' heel for 529s may emerge in 2011 if Congress does not sustain the recent tax repeal, which ends in 2010. We could then see the reinstatement of taxes on 529 distributions.
Even if that should happen, the advantages of 529 accounts remain formidable. These plans allow the creator of the account to withdraw the amount he or she has contributed at any time. Your clients should love that option — irrevocable gifts often turn sour because the kids change, marry someone your client does not like, fail in business and so forth. You have heard all the stories.
Equally important on the estate planning side is that the death of your client usually does not cause all of the 529 account balance to be included in his or her estate. This is true notwithstanding the fact that your client can make withdrawals.
The federal contribution limits are $10,000 per person or $20,000 for a couple, for each beneficiary. Your client can bunch five years' worth of contributions into one year, so the couple can contribute $100,000 every five years, singles $50,000. These amounts are quite attractive options in sheltering those dollars from both income and estate taxes.
Children and grandchildren are the usual beneficiaries. Section 529 of the tax code and the generation-skipping trust (GST) rules treat gifts to grandchildren as eligible for the annual exclusion (no gift tax), and these gifts are exempted from the GST tax at least until 2010 when the GST and the estate tax, but not the gift tax, are repealed.
The biggest planning downside for 529 plans is that some states have Draconian restrictions on them. Some allow contributions of only $100,000 in the aggregate for all of the beneficiaries, and investment options may be limited and unattractive. Slip around these potential problems by putting the account in a state with reasonable restrictions, like New Mexico, Colorado, New Hampshire or Maine.
All planning is individualized and the 529 accounts, like shoes, come in different shapes and styles. But the advantages are compelling, so finding a plan that fits is worthwhile.
Yes, uncertainties about future tax treatment exist, but that's always the case. Congress may surprise us all and let the repeal remain intact in 2010.
Roy M. Adams is worldwide head of the Trusts and Estates Practice Group at the law firm of Kirkland & Ellis in New York. In addition to his law practice, he lectures extensively on estate planning and has authored several professional texts including “Contemporary Estate Planning: A Definitive Guide to Planning and Practice.”